Mid-Cap Funds A Better Choice
One of the biggest reasons why an investor invests in any security is to generate better returns. Mid-cap funds are the ones that will help him to achieve this objective. But that is not the only reason. Mid-cap funds tend to generate returns better than the large-cap funds in the long run. Read on to understand why
As with a pendulum effect, after showing extraordinary return in the year 2017, mid-cap funds for the next two consecutive years i.e. 2018 and 2019, on an average, posted a sharp underperformance.
While in 2018 mid-cap funds generated negative return of 12 per cent, large-cap funds yielded marginally positive returns. Nonetheless, on an average, year-till-date in CY20 mid-cap funds have outperformed the Nifty 50. Meanwhile, large-cap-dedicated funds, on an average, are up by around 5 per cent year-till-date and the mid-capdedicated funds are up by 13 per cent.
The chart alongside clearly shows that there is no single incidence since year 2012 when mid-cap funds on an average have underperformed large-cap funds for two consecutive years. The last time they underperformed was in 2013; post that in 2014 mid-cap funds almost gave returns twice that of the large-cap funds. For the next two years also they continuously outperformed large-cap dedicated funds.. Therefore, we see that once the mid-cap funds underperform the large-cap funds for any period of time, they tend to return with vengeance. Moving beyond the annual (calendar year) performance, we tried to analyse the pattern of returns of large-cap and mid-cap funds through their respective indices. For this we checked their three years’ rolling returns of Nifty and Nifty Mid-Cap 150 since 2005 as annual returns calculated above give us limited data to assess the true pattern of returns of large-cap and mid-cap categories.
Three Year Rolling Returns of Large-Cap & Mid-Cap Indices
What we observed is that after underperforming in 2013, mid-cap funds gave superlative returns for the next three years. Between start of 2014 and end of 2017, we saw that mid-cap index gave a cumulative return of 246 per cent compared to 172 per cent return given by the large-cap index in the same period.
Why Mid-Cap Funds?
There are some clear reasons for being in favour of mid-cap funds. These are as follows:
1) Better Returns:One of the biggest reasons why an investor invests in any security is to generate better returns. Mid-cap funds are the ones that will help him to achieve this objective. Mid-cap funds tend to generate returns better than the large-cap funds in the long run. If you had invested Rs1 lakh in a mid-cap fund at the start of June 2008, the value of your investment on an average would have become Rs4.44 lakhs now, giving you an annualised rate of 13.14 per cent. If you had invested the same amount in a large-cap-dedicated fund, your investment would have become Rs3.77 lakhs, giving a CAGR of 11.7 per cent, thus implying that mid-caps outperformed large-caps by 1.5 per cent every year.
To dig deeper and analyse further the returns generated by mid-cap funds, we checked the rolling returns of different periods starting from 3-10 years. What we have observed is that with increasing number of years, mid-cap-dedicated funds tend to show better returns. The number of times the mid-cap funds generate returns better than large-cap funds increases. For example, in a three-year period of rolling returns there are various periods when large-cap funds have generated returns better than the mid-caps.
Nonetheless, as the period increases, as for example over a 7-10 years’ period, there is not a single incidence when mid-capdedicated funds underperformed large-cap funds. Hence, purely from a return perspective, mid-cap-dedicated funds definitely outperformed large-cap funds.
2) Moderate Risk: There also remains a common misconception that mid-cap funds are risky and tend to be more volatile. At an individual level, mid-cap stocks may show more volatility but at the portfolio level or as a fund they tend to be more stable. The chart below shows the three-year rolling standard deviation of daily returns of mid-cap and large-cap funds. From 2011 to 2016 the returns provided by mid-cap funds were less volatile compared to large-cap funds. From 2017 they became more volatile; however, at the absolute level they have come down substantially and are now less volatile than large-cap funds.
Measuring risk by standard deviation purely because it was used by Harry Markowitz in his portfolio theory may not present the risk picture in its entirety. Therefore, we measured the risk on different parameters. The table below shows the risk parameters of large-cap and mid-cap-dedicated funds. It shows that mid-cap funds carry more risk than large-cap funds but not to the extent an investor would think.
Therefore, when we combine risk-adjusted return, we see that mid-cap funds tend to generate better risk-adjusted return presented by Sharpe Ratio.
Why Mid-Cap Funds Now?
We may be staring at the same inflection point now. After underperforming for more than two years, we may see the midcap category gaining traction now. The current recovery in the frontline indices has led them to trade at a lifetime high. Even the funds dedicated to large-caps have fully recovered from their low. On the other hand, the mid-cap funds on an average are yet to reach the peak they had reached in the month of January 2018. Hence, in the last two and half years they have grossly underperformed the large-cap funds and have generated negative returns. Since in the long run mid-cap funds tend to perform better than the large-cap funds, going by reversion to mean, we may see mid-cap funds start outperforming large-cap funds from here on.
Besides, what also favours the mid-cap category now is the improving economic condition. After showing a sharp cut in the economic growth in the first quarter of FY21, the economic scenario is fast returning towards normalcy. Mid-cap companies will be the chief beneficiaries of such a reversal in economic growth. Large-cap companies that are generally market leaders of their sector have many levers to play during the economic downturn and hence are less impacted by a slowing economy. However, in case of mid-cap companies they face the brunt in case of deceleration in the economy. However, when the economy turns the corner and growth rate increases we see that mid-companies benefit the most. Fund dedicated to mid-cap companies have higher beta with respect to GDP growth.
Their fortunes are closely tied to economic growth. Even before the pandemic induced a fall in economic activity, the Indian economy was slowing down, as was reflected in the performance of the mid-cap funds. Therefore we saw such an underperformance of the mid-cap funds. The current high frequency growth data shows a sustained recovery trend. September witnessed good growth and even the incoming data for October is displaying growth on a yearly basis. Indeed, power demand, e-way bills, GST collections, rail freight and automobile sales have sustained the positive yearly growth trend.
The manufacturing PMI has increased to its highest reading since October 7 while services’ PMI rose to 54.1 after seven months of contraction. Early incoming data for November shows that the trend has held up with growth in power demand, e-way bills, exports and rail freight remaining in the positive territory. All this supports the mid-cap stocks and funds dedicated to such stocks. The stock market being the lead indicator tends to perform before the economy recovers and hence the last one month outperformance of the broader market indices and the funds dedicated to that should be looked at with this perspective. If the economy is on a recovery path we may see these funds generating far better returns going ahead .
What are Mid-Cap Funds?
All listed companies are categorised into three categories based on their market capitalisation by market regulator SEBI. They are large-cap, mid-cap and small-cap. According to SEBI, mid-cap companies are those which are ranked between 101 and 250 in the list of companies according to market capitalisation. Mid-cap funds are those that invest at least 65 per cent of the corpus in equity and equityrelated instruments of mid-cap companies. The industry body of Indian mutual fund, AMFI, comes out with a list of companies in every category every six months. Currently the market capitalisation of the 101st company on the list is around Rs30,000 crore while the market capitalisation of the 250th company is around Rs9,500 crore.
Pointers for Investing in Mid-Cap Fund
There are two important aspects that an investor should look at before investing in mid-cap funds. First is the risk-tolerance capability of the investor and second is the period for which he needs to invest. Mid-cap funds are more volatile than the large-cap funds and hence investors who do not have the stomach to tolerate such volatility should better avoid mid-cap funds. The table below shows the top five draw-downs of mid-cap funds since 2005. We see that the funds are yet to return from the peak reached in 2018.
An analysis of the top five draw-downs of the large-cap and mid-cap funds points to a couple of aspects about mid-cap funds. First, the fall or correction in the mid-cap funds is much deeper than the large cap funds. For example, during the great financial crisis (GFC) of 2008, large-cap funds on an average dropped by 60 per cent whereas in the same period mid-cap funds on an average lost 73 per cent. In addition to the depth, the length of the fall was more in the case of mid-cap funds. For example, in 2008, mid-cap funds took 1,295 days to recover from the low reached on March 9, 2009. In case of large-cap funds, it took only 697 days to recover from the trough. Even in the current scenario we see that the mid-cap fund is yet reaching its peak.
In addition to the length and breadth of fall, what is also important is that the chance of generating negative returns in a smaller period is higher for mid-cap funds compared to large-cap funds. In the period between June 2008 and November 2020 out of a total of 2,306 instances, there were 172 times or 7.5 per cent of time that mid-cap dedicated fundsgenerated negative returns compared to only 1 per cent of the time when large-cap dedicated funds generated negative returns. Hence, investors willing to plunge into the pool of mid-cap funds should be prepared for longer investment horizon and at times an extended period of negative returns.
Besides, if you are selecting the funds based on your goals then mid-cap funds are best suited for your long-term goals. If the goal tenure is more than seven years then mid-cap funds may suit your goal(s) and if you are looking for a shorter period, then mid-cap funds may not be the best choice for investing. Also, the mid-cap fund should form part of your ‘satellite’ holdings and can be around 30-35 per cent of the portfolio depending upon your age and risk appetite.
Selecting the Best Mid-Cap
MFs In India there are more than 4,000 listed companies; however, actively researched companies are around 300. Therefore, there is very little sell side research in many mid-cap stocks so that fund houses have to build their own research capabilities to identify and invest in mid-cap stocks. Hence, you need to check the following points before investing in a mid-cap fund.
✓ Consistent Performer: The fund that you should invest in should be a consistent performer. This means that the performance should always be in the first or second quartile in its category. It should have consistently outperformed its peer and benchmark.
✓Performance during Downturn: The fund that has been able to withstand the downturn in a better manner or has managed to arrest its fall is likely to be an outperformer in the longer period.
✓ Size of AUM: Assets under management (AUM) may also be an important consideration as funds with higher AUM can typically have higher market trading volumes which positively influence the liquidity of a fund. Nevertheless, many a times, higher AUM can affect its performance negatively. Hence, it is better to select funds that have AUM of around median category.
✓ Years of Existence: The fund that has a longer history should be ideally preferred as it shows that it has been able to withstand many economic and market cycles and has survived.
✓ Expense Ratio: There is always an inverse relation between fund performance and its expense ratio. Therefore, pick a fund that has a lower expense ratio compared to similar funds.
✓ Quality Fund House: Not all the asset management companies have built the same capability of investing in quality mid-cap companies. Therefore, opt for a fund house that has an experienced in-house research team that has good coverage and techniques to build a robust portfolio.
These are the best funds based on last five-year data and above criteria:
✓ Axis Mid-Cap Fund
✓ DSP Mid-Cap Fund
✓ L&T Mid-Cap Fund
✓ Kotak Emerging Equity Scheme
✓ Franklin India Prima Fund.